The Market At 6000

I had a coffee this week with a private equity investment manager, who was explaining that he never pays more than 4-6 times EBITDA (cash flow) for a business. And that’s pretty typical for those who actually buy businesses – you want a cash payback of no more than five years, or a very good reason for something longer (that is, “strategic reasons” – which is to say, you really want it).

Then I looked at the sharemarket, which has had a pretty good October, rallying 5% (total return) from October 5th to finish the month just short of 6000, before going through that long-standing resistance level next day (on the All Ordinaries).

The October rally was a far cry from some past Octobers and took the market’s forward price earnings ratio (PE) to 15.4 times, slightly above the long-term average of 14.7. So a bit expensive, but nothing scary.

But the more fundamental question is: why would you pay more for a piece of a company listed on the ASX than you would if you bought the whole thing?

After all, listed companies often have absolute dopes or crooks running them, that you can’t control, whereas if you buy the whole business at least you can sack them, so it’s arguably less risky.

Of course earnings as used in PE ratios are not the same as EBITDA. That clumsy acronym stands for “earnings before interest, tax and depreciation and amortisation”, and roughly equates to cash.

The reason people buying whole businesses tend to use that instead of profit is because it’s harder to fabricate and cash flow tells you what the business itself is doing, rather than what the accountants want you to think it’s doing. Profit is a made up number, while cash is in the bank.

The difference between them varies by company so it’s hard to generalise – it depends on the amount of debt, the value of fixed assets and the hourly rate of the tax lawyers they’ve got.

But here’s a random example: Wesfarmers’ 2017 net profit was $2,783 million, or 254.7c per share, producing a trailing PE ratio (now) of 16.6 times. Tax was $1,265 million, interest $264 million and depreciation and amortisation $1,266 million, for total EBITDA of $5,668 million, or $5 per share.

That produces an EBITDA multiple of 8.5 times, about half the PE.

So here’s the thing: the PE ratio shows Wesfarmers to be a little bit higher than the market and slightly above average, but the EBITDA multiple makes it look almost twice as expensive as what you might call a normal business transaction.

My point is that there’s nothing particularly sensible about paying 15 times earnings for part of a business (that is, all ASX listed shares). The only reason it works is that everybody else is OK with it, so the market tends to “mean revert” around that sort of valuation.

Occasionally the market PE ratio goes above 20 and below 10, but it always reverts back to the half-way mark of 15. So on a strict valuation basis, the sharemarket is probably a buy at a PE of 10 times, probably a sell at 20, and probably a hold at 15 – where it is now.

I say “probably” because the PE is only one part of the equation: it might still go up when the PE is 20 – it just needs support from rising earnings to do so.